$1 billion six-year B-1 term loan, a $250 million 3.5-year B-2 term loan, and a $450 million five-year revolver. The '2' recovery rating indicates our expectation of substantial (70%-90%) recovery in a payment default scenario. We also raised our issue rating on the $64.985 million Series 2009A and $60.015 million Series B Development Authority of Clayton County (Georgia) Special Facilities Revenue Bonds (Delta Air Lines Inc. Project) to 'B-' from 'CCC+'. The 'B' corporate credit rating and positive outlook remain unchanged.

Rationale

Our 'B+' issue rating and '2' recovery rating are each one notch lower than the 'BB-' issue rating and '1' recovery rating on debt that Delta's Pacific routes currently collateralize. This is mostly because the total amount of debt (which includes, in addition to the newly issued debt, $250 million of new other financing, not yet described further, and an assumed $125 million of hedging-related liabilities) is more than the obligations that the routes currently secure. The total obligations, pro forma for the new financings are $2.1 billion, compared with $1.75 billion currently. Furthermore, the existing debt consists of about $1.45 billion of senior debt and hedging obligations, and $306 million of second-lien debt. The collateral consists of Delta's Pacific international route authorities from the U.S. to Japan, China, Hong Kong, Korea, Australia, and other countries in or bordering the Pacific Ocean. Also included are related take-off and landing slots (except at John F. Kennedy Airport in New York) and gate leasehold interests at U.S. and overseas airports needed to operate the Pacific network.

Security interest in collateral

Delta indicates in its offering materials that it does not plan to seek to perfect security interests in non-U.S. collateral, principally airport takeoff and landing slots. This is consistent with what other U.S. airlines have said in connection with other routes financings. The potential implications of this have been the subject of considerable debate recently, in connection with AMR Corp.'s bankruptcy--subsidiary American Airlines Inc.'s 7.5% notes are secured by trans-Atlantic routes and, in particular, the airline's valuable takeoff and landing slots at London's Heathrow International Airport.

International routes and related slots and gates have been used as collateral in various bank credit facilities and secured notes, including those of airlines that reorganized in Chapter 11 bankruptcy proceedings. We are not aware of successful legal challenges to the security for these facilities and notes. What has changed in recent years, however, is the source of collateral value for lenders against airlines' international operations. Appraisers value such collateral as a business operated by the airline currently using them, estimating future earnings or cash flows, and discounting them to arrive at a value. The appraisers do not separately identify value attributable to routes, slots or gates, which would be difficult given the appraisal approach they use.

Historically, international routes were a scarce right, granted by governments under bilateral aviation treaties, and the barriers to entry they created were a source of value. Slots and gates had value, but they were useless without the routes. Since new, more liberal aviation treaties signed between the U.S. and European Union in 2007 (which took effect in 2008) and U.S. and Japan in 2009 (which took effect in 2010), routes are much more freely available. Following those changes, the principal barriers to entry remaining in U.S.-EU markets are the slots and gates at Heathrow Airport (which is slot constrained), and in the U.S.-Japan market similarly the slots and gates at Tokyo's Narita International Airport (there are still route limits at Tokyo's Haneda Airport). The U.S.-China bilateral treaty still limits the availability of flights, so the principal barrier to entry (and source of scarcity value) remains the routes. Other major Asian markets that Delta serves, including Australia, Korea, and Hong Kong, have liberal aviation treaties that do not constrain route rights. With the aviation treaty changes of the past few years, more of the scarcity value of rights used in international service has shifted somewhat to these non-U.S. jurisdiction rights.

AMR has not indicated whether it will ask the bankruptcy court judge to rule that the American's 7.5% noteholders are undersecured because the security interest in the Heathrow slots is not perfected. If AMR did so, it could potentially decrease the compensation that it has to pay to the noteholders, but it would also likely make the international routes useless as collateral for future borrowings. There could also be practical difficulties in quickly securing new route rights to EU countries (even given the "open skies" treaty with the U.S.) if noteholders were able to enforce a security interest on the current routes and at some point prevent American from operating them. Any interruption in trans-Atlantic service would be very costly to AMR. In our analysis of Delta's secured bank facilities, we applied greater stresses to the value of international routes and related assets to countries with whom the U.S. has liberal aviation treaties because of the lower barriers to entry and greater competition in those markets. We did not explicitly model a legal outcome that reduces the value of collateral because of the lack of perfection in non-U.S. takeoff and landing slots, but we could change our analysis if developments in the AMR bankruptcy cause us to reconsider.

Valuation of international routes collateral The international route rights are U.S. assets and their legal status is clearer. Transfer is subject only to approval by the U.S. Department of Transportation (DOT), not foreign governments, and the DOT would have a public policy interest in transferring them to a new user to maintain air service. The U.S. government has not blocked the transfer of routes, either inside or outside an airline's bankruptcy in the past. Under bilateral aviation treaties, airlines can use such route rights (with permission from the DOT) to fly from any city in the U.S., meaning that these routes would potentially be of interest to other airlines that do not intend to fly from the airports Delta uses. Because United Continental already has similar Pacific routes, it would not have an interest in (nor would regulators likely allow it to) buy Delta's routes in a liquidation. AMR and US Airways Group Inc. would be logical potential buyers. However, our recovery analysis of Delta assumes reorganization as the most likely outcome in bankruptcy, and it is the value to a reorganizing Delta that is the focus of our recovery analysis.

An independent appraiser (Morten Beyer & Agnew; mba) valued the international route rights at $3.28 billion to $3.95 billion, depending on what discount rate is applied to projected future free cash flows. The appraisal derived a "current market value" defined as "the expected price at which a transaction would occur between a willing buyer and seller, neither being forced to buy or sell" (which would not apply in a bankruptcy scenario). The valuation uses a discounted free cash flow approach, based on Delta's revenues and operating costs on these routes and on the appraiser's projections.

Standard & Poor's focuses on the highest discount rate in the range that the appraiser uses because of the risks relating to the airline industry. These risks, which apply even to relatively attractive, high-growth markets such as trans-Pacific routes, include high fuel prices and gradually increasing competition (made possible by liberalization of aviation treaties and the emergence of larger and more aggressive Asian airlines). In addition, after comparing the appraised values to those of United Continental for similar routes, we used $3 billion, somewhat lower than the low-end appraised value (and consistent with our assumption when we last undertook a recovery analysis of Delta, in May 2012), as our starting point value.

Stress scenario recovery results We then applied a reduction to the appraised values of these routes in the simulated default scenario. The appraisal does not break out value for separate major markets, such as Japan and China, but we estimated 25% for China and Hong Kong routes and 75% for Japan and other Pacific markets. We applied a 35% discount to the China and Hong Kong routes and a 45% discount to the other routes, for a weighted average 42% discount. Northwest Airlines Inc., which Delta acquired after the two airlines emerged from bankruptcy, historically was stronger in Japan than United Air Lines, though United had more service to most other Asian destinations. This continues to be the case, but Delta's Japan operations face more difficult competition now that United Continental and American Airlines each have antitrust-immune alliances with the two leading Japanese airlines, All Nippon Airways and Japan Airlines, respectively.

The discrete asset valuation assumptions yield a stressed collateral value of about $1.73 billion. We estimate about $2.1 billion in first-lien, Pacific-route-secured claims outstanding (revolver, term loans, other debt outstanding, and hedging obligations plus six months of accrued interest on debt). In addition to $1.92 billion of secured debt ($2 billion less two years' scheduled amortization), we assume the collateral covers $125 million of pari passu cash management and hedging obligations to the bank lenders (per the credit agreement, the basket is $250 million for hedging obligations, but we assume half of that amount). Our analysis also assumes a claim for six months of interest (estimated $61 million). Therefore, under the simulated default scenario, collateral coverage is 81%, indicating a '2' recovery rating. Under our criteria, this results in a 'B+' issue rating, one notch higher than our 'B' corporate credit rating on Delta.

We do not rate any of Delta's senior unsecured debt. However, we do rate certain airport revenue bonds that are secured only by payments from Delta (and not by any collateral or leasehold interest in the related airport facility), and which we treat as equivalent to senior unsecured debt. Our modeling of a Delta default scenario resulted in an estimated recovery to senior unsecured claims in the 10%-30% range, consistent with a '5' recovery rating. The change is due mainly to Delta's debt paydown. Although we do not assign recovery ratings to airport revenue bonds of the type described above, we rate them at a level consistent with where we would rate senior unsecured debt. Accordingly, we are raising our issue rating on the $64.985 million Series 2009A and $60.015 million Series B Development Authority of Clayton County (Georgia) Special Facilities Revenue Bonds (Delta Air Lines Inc. Project) to 'B-' from 'CCC+'.

For the complete recovery analysis, please see our recovery report on Delta to be published on RatingsDirect following this report.